You need to start watching the U.S. dollar

NEW YORK (MarketWatch) — After a long, sleepy stretch, the dollar is breaking out to the upside, and it’s not just currency traders who need to pay attention.

The ICE dollar index
DXY, +0.00%
which tracks the U.S. currency against a basket of major rivals, quietly pulled off a breakthrough this week, punching to its highest level since September and trading recently at 82.044. The currency extended big daily gains Wednesday versus the euro and Japanese yen after the minutes from the Federal Reserve’s latest meeting struck a surprisingly hawkish note. Read more about the day’s currency-market action

“There’s a late-summer feel to the weather and a spring in my step as the dollar has finally slipped its moorings and edged up and out of the doldrums,” said Société Générale global macro strategist Kit Juckes, in a note.

A sustained dollar rally could have important implications for U.S. and multinational companies, potentially resounding across the stock market and other asset classes.

Short-term technical indicators point to more upside for the dollar index, writes Greg Harmon, founder of Dragonfly Capital, in a Wednesday blog post. And if the index’s move over the past year turns out to form “rounded bottom” or a “cup and handle” — both are technical patterns — the index could have room to test the 83.50 level, he says.

That would be a “big move for this stable asset and one that would garner even more attention from longer-term investors,” Harmon wrote. “For now, the short-term trader can be excited, but it is still boring for the investor. But it is time to start paying more attention.”

What’s behind the dollar rally? Diverging monetary policy is one oft-cited reason. The U.S. Federal Reserve is winding down its quantitative-easing program and is seen on track to begin hiking interest rates next year. That stands in contrast to the Bank of Japan, which remains in quantitative-easing mode, and the European Central Bank, which is widely expected to be forced reluctantly down the road of outright QE to avoid the Japanification of the euro-zone economy.

As a result, even though U.S. bond yields remain extremely low, they’re more attractive to investors than yields in Japan and Germany.

“Over the really long term, the dollar tracks real U.S. rates [rates minus inflation] as closely as it tracks anything,” Juckes said.

Strategists warn this could be another false dawn for dollar bulls. But if the rally does have legs, it could have implications for stocks as well.

Over a 20-year period, the dollar index’s correlation coefficient with the S&P 500
SPX, -0.23%
was 0.38, according to Investopedia. The positive coefficient means that when the value of the dollar rises, the stock index tends to rise, too. In this case, around 38% of the S&P’s move are associated with the movement of the dollar.

But it gets more complicated. Matthew Weller, senior technical analyst at Forex.com, notes that the correlation “oscillates between strongly positive and strongly negative depending on the trading environment we’re in.”

This chart via StockCharts.com shows the 26-week correlation between the S&P 500 and the dollar index over the past three years — a pattern Weller notes is “relatively inconsistent.”

Stockharts.com

“When we’re in a risk-on/risk-off environment, like we were in midst of the Great Financial Crisis, the correlation tends to be negative (ie. stocks fall when the dollar rises and visa-versa),” Weller said in an email. “Lately, the correlation has been strongly positive, reflecting traders’ demand for U.S. assets amidst the recent strong economic performance.”

Whether the positive correlation continues should the dollar extend its rally is an important question for investors. If a stronger dollar is seen crimping earnings, it could spell trouble for equities. But if the rally is built on expectations the U.S. economy will continue to outpace its peers, it wouldn’t necessarily stand in the way.

The relative strength of the U.S. economy and the stock market since the worst of the financial crisis has helped to boost the dollar, said Sameer Samana, senior international strategist at Wells Fargo Advisors, in a note.

“We believe the expectation for faster growth in the U.S. should lead to continued outperformance by U.S. equities,” Samana said. At the same time, a weaker euro and yen should boost earnings prospects for companies based in the euro zone and Japan, he said, and recommends a tactical overweight position on developed-market equities.

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